For years, a key driver for U.S. stocks has been the idea that, no matter what potential headwinds there may be, they were more attractive than bonds. But now, with major equity indexes at records and valuations stretched by many metrics, that argument has become less compelling.
Adding to the uncertain environment for market participants, bond yields remain low by historical standards, meaning that the primary alternative to equities doesn’t look very alluring either, offering investors few appealing options.
“There’s been an expression for stocks in markets: TINA. It stands for, ‘There Is No Alternative.’ I think the most appropriate expression for this market is CITA. Cash Is The Alternative,” said Doug Kass, president of Seabreeze Partners.
“I’m the polar opposite of Mae West,” he added. “West said she liked two types of men: domestic and foreign. I don’t like stocks or bonds.” West was an outspoken Depression-era actress and comedian.
While the economy does have some elements in its favor, including a strong labor market, investors are increasingly seeing warning signs. Economic growth has been tepid, while expectations for corporate earnings have been coming down.
Stocks have done well regardless, with the S&P 500 SPX, +0.03% up nearly 8% thus far this year, but that has stretched valuations to a level that some say is unsustainable. By one measure, prices are at their highest level since 2004.
In another potential warning sign, the nearly uninterrupted rise of stocks has been matched by a steady increase in investors using borrowed money to make investments on Wall Street.
Indeed, total margin debt hit a record $549.2 billion in April, according to the most recent data from the New York Stock Exchange, up 2.3% from March, and up more than 20% year-over-year.
A similar leverage trend has played out among the smart-money set. Hedge-fund leverage reached its highest level since the financial crisis, according to a recent Goldman Sachs research note to clients.
“Net leverage is now at 73%, roughly matching the post-crisis highs set in 2013, while gross exposures have leapt to 230%, well above any levels in recent years,” the investment bank wrote. “Short interest as a percent of S&P 500 market cap remained at 1.9%, the lowest level in five years.”
Experts disagree on whether high levels of leverage are inherently bearish, but some view it as a sign of complacency, particularly given the low short interest—which indicates people betting on a market decline—and low volatility. The CBOE Volatility index VIX, -1.80% is currently below 10—half its long-term of 20.
“The net exposure by hedge funds is important. If they’re significantly long on the net exposure side, then there’s not as much to move markets further in the short run,” said Eric Green, senior portfolio manager and director of research at Penn Capital Management.
Wells Fargo recently downgraded its view on large-cap stocks, in part due to concerns about equity valuations.
“When compared with the yield on the 10-year Treasury note, the S&P 500 Index’s earnings yield now is more in line with historical s than has been the case in recent years,” Wells Fargo wrote in a note to clients. “With U.S. interest rates expected to rise, the relative attractiveness of U.S. large-cap stocks versus Treasury bonds may deteriorate as we move through the balance of 2017.”
According to the following Wells Fargo chart, stocks remain slightly more attractive than bonds by this measure. However, the degree to which this is true has dropped by about half over the past year.
“It also is important to keep in mind that we are most likely moving into a period during which Treasury yields will rise slowly,” wrote the team of Wells Fargo analysts, led by Stuart Freeman, the bank’s co-head of global equity strategy, who forecasts that stubbornly low Treasury yield will rise in 2018. “Thus, the markets are moving toward environments within which they will slowly face greater competition from other financial-vehicle returns.”
The U.S. 10 Year Treasury Note TMUBMUSD10Y, -0.47% currently yields 2.26%, up significantly since an all-time low below 1.4% in July, but down from a recent peak of 2.64% in December. Bond yields move inversely to bond prices, so the recent downward bias in yields means that bond buying has occurred alongside stock indexes climbing to records, a relatively unusual occurrence given that those assets tend to move in the opposite directions.
So, which is pricier?
Seabreeze’s Kass estimated that stocks were “more than 10% overvalued,” though “I prefer to think of it as there being a three to four times multiple of risk versus reward.”
Bonds, he added, were “materially overvalued.”
“The 10-year yield is typically in line with the nominal GDP, which is real GDP plus inflation,” he explained. “If you assume 2% inflation and 2.5% growth, nominal GDP would be 4.5%. Instead, the 10-year is at 2.26%. That gives you a sense of how overvalued bonds are, relative to historical s.”